A defined benefit plan turns a formula into a liability: the client promises a benefit, and the balance sheet carries the present value of that promise less the assets set aside to pay it. The numbers come from an actuary, but every input behind them is management's, and the auditor has to test those inputs.
This guide covers how to recognize a defined benefit plan, the measures that matter, the net periodic cost entries and the audit tests.
Is the plan defined benefit or defined contribution?
Start with the defined contribution test. A defined contribution plan gives each participant an individual account, and the benefit depends on contributions, investment experience and allocated forfeitures, minus plan expenses. A 401(k) plan with an employer match is one. See /us/blog/401k-audit-requirements. A plan with defined benefit features gets defined benefit accounting even when it looks like an account plan.
A defined benefit plan gives a determinable benefit under a formula, such as $100 a month for each year of service or 1% of final-year pay for each year of service. A cash balance plan is a defined benefit plan. Participants see a hypothetical account balance, but the employer, not the employees, bears the investment risk. Classification follows substance, not the label. A plan that looks like an account plan but leaves the employer with the investment risk is a defined benefit plan in substance.
What are the PBO, ABO and funded status?
The projected benefit obligation (PBO) is the actuarial present value of the benefits the plan formula attributes to service rendered to date, using projected future pay levels where benefits depend on pay. The PBO uses the projected unit credit method, which treats each year of service as a unit of benefit and measures each unit.
The accumulated benefit obligation (ABO) uses the same present value approach but only service to the measurement date, with current and past pay, and excludes assumed future salary increases.
Plan assets are investments such as stocks and bonds that are segregated and restricted, usually in a trust, to provide the benefits. Assets that are not segregated in a trust or otherwise effectively restricted so the employer cannot use them for other purposes are not plan assets. A trust that explicitly makes its assets available to the employer's general creditors in bankruptcy, as a rabbi trust does, does not qualify (KPMG). Plan assets are measured at fair value. The net funded status, which is plan assets at fair value less the PBO, is the net pension asset or liability on the balance sheet. Obligations and assets are measured as of fiscal year end. If the year end is not a month-end, the entity may use the closest month-end, consistently from year to year (KPMG).
What goes into net periodic benefit cost?
| Component | What it is | Where it goes |
|---|---|---|
| Service cost | Benefits earned in the period | Operating income, with other compensation |
| Interest cost | PBO accreted at the discount rate | Outside operating income |
| Expected return on plan assets | Expected long-term rate applied to the market-related value of plan assets | Outside operating income, as a reduction of cost |
| Amortization of prior service cost | Cost of plan amendments, recorded first in OCI | Outside operating income |
| Amortization of gains and losses | Deferred amounts outside the corridor | Outside operating income |
Gains and losses from asset returns, experience and assumption changes are deferred in accumulated other comprehensive income, unless the entity's policy is to recognize them in income immediately (KPMG). Minimum amortization applies only to amounts outside the corridor, which is 10% of the greater of the benefit obligation and the market-related value of plan assets at the start of the year (KPMG). Amortization has no net effect on total comprehensive income because it is a reclassification out of OCI.
An illustration. The plan starts the year with a PBO of $1,000,000 and plan assets of $700,000 (market-related value equal to fair value). The discount rate is 5% and the expected return is 6%. Service cost is $80,000. Ignore amortization.
- Interest cost: $1,000,000 x 5% = $50,000
- Expected return: $700,000 x 6% = $42,000
- Net periodic cost: $80,000 + $50,000 - $42,000 = $88,000
| Account | Debit | Credit |
|---|---|---|
| Pension expense, service cost (operating) | 80,000 | |
| Pension expense, other components (non-operating) | 8,000 | |
| Net pension liability | 88,000 |
The employer then contributes $60,000 to the trust.
| Account | Debit | Credit |
|---|---|---|
| Net pension liability | 60,000 | |
| Cash | 60,000 |
If the discount rate falls at year end and the PBO rises by $70,000 because of the new rate, that is an actuarial loss. It is deferred in other comprehensive income, not expensed.
| Account | Debit | Credit |
|---|---|---|
| Other comprehensive loss, actuarial loss | 70,000 | |
| Net pension liability | 70,000 |
Which assumptions matter most?
- Discount rate. The objective is the amount that, invested at the measurement date in high-quality debt, would fund the benefits when due. The SEC staff has indicated that high quality means bonds, typically corporate, rated AAA or AA (KPMG). Discount rates implicit in futures contracts are not appropriate (KPMG). The rate is reevaluated at every measurement date, and a methodology change needs a documented rationale.
- Expected return on assets. It reflects the portfolio held at the measurement date, forward-looking market expectations, net of expected costs, and a best estimate rather than an optimistic one.
- Mortality. The assumption must be a best estimate that reflects the life expectancy of the plan's own participants. KPMG believes entities should consider the Society of Actuaries' most recent mortality table and improvement scale for US plans, including data released after the measurement date but before the statements are issued.
- Salary growth. It must be consistent with the inflation and discount rate assumptions.
- Market-related value. Market-related value is either fair value or a calculated value that recognizes changes in fair value systematically over not more than five years, and the method is applied consistently from year to year for each asset class (KPMG). Funded status is still measured at fair value.
Audit angle
Pension numbers are an actuary's output, so the audit work is on inputs, completeness and the specialist's work. See /us/blog/using-the-work-of-a-specialist-au-c-620 and /us/blog/auditing-accounting-estimates-au-c-540-sas-143.
- Obtain the actuarial report and the plan document. Confirm the plan formula and any amendments are what the actuary valued.
- Test the census data. The participant data feeding the valuation drives the PBO. Agree a sample of birth dates, hire dates, pay and status to payroll and HR records.
- Challenge the discount rate. Compare it to a high-quality bond yield curve or index at the measurement date, and confirm the method matches the prior year.
- Challenge the expected return. Compare it to the asset allocation and to independent capital market forecasts.
- Test plan assets. Confirm balances with the trustee or custodian, agree the fair value to statements, and review the hierarchy level used. See /us/blog/asc-820-fair-value-measurement.
- Roll forward the obligation and the assets. Agree service cost, interest cost, contributions, benefits paid and actuarial gains and losses to the actuarial report and the ledger.
- Check the OCI and amortization. Recompute the corridor and the amortization, and confirm that reclassification out of OCI ties to the expense.
- Check classification. Confirm service cost is in operating income and the other components are outside it.
Common misstatements: an unrecorded net pension liability, a discount rate not updated at the measurement date, a rabbi trust counted as plan assets, a hybrid plan accounted for as defined contribution, and actuarial losses expensed instead of deferred.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- KPMG, Employee benefits Handbook, September 2026 (plan assets, measurement date, market-related value, corridor, discount rate and mortality assumptions): https://kpmg.com/kpmg-us/content/dam/kpmg/frv/pdf/2026/employee-benefits.pdf
- PwC Viewpoint, Pensions and employee benefits guide, 1.4 Defined contribution plan: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-1-PEB/peb_1-4.html
- PwC Viewpoint, Pensions and employee benefits guide, 1.6 Hybrid plans: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-1-PEB/peb_16.html
- PwC Viewpoint, Pensions and employee benefits guide, 2.2 Benefit obligation measures: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-2-PEB/PEB_22.html
- PwC Viewpoint, Pensions and employee benefits guide, 2.4 Financial assumptions when measuring the plan obligation: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-2-PEB/2_4_Financial_assumptions_when_measuring_the_plan_obligation.html
- PwC Viewpoint, Pensions and employee benefits guide, 2.3 Demographic assumptions: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-2-PEB/PEB_23.html
- PwC Viewpoint, Pensions and employee benefits guide, 2.6 Plan assets: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-2-PEB/2_6_Plan_assets.html
- PwC Viewpoint, Pensions and employee benefits guide, 2.7 Measurement date: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/Chapter-2-PEB/2_7_Measurement_date.html
- PwC Viewpoint, Pensions and employee benefits guide, 3.2 Composition of net periodic benefit cost: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/pensions-and-employee-benefitspeb/peb_guide/chapter_3/32_composition.html
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